System rewards key creditors and executives

stockholders pay steep price

As public companies lurch toward a second year of record bankruptcy filings, wounded shareholders should brace themselves for similar shocks in coming years--even if the economy improves dramatically.

Corporate leaders have never had such strong incentives to choose bankruptcy as a way out of their often self-inflicted financial problems, a Tribune review of the bankruptcy system shows.

The excesses of the past decade play a key role, including a swelling appetite for leverage and an erosion of discipline in financial reporting. In addition, a fast-growing market for distressed corporate debt is encouraging companies to emerge from bankruptcy proceedings with enormous liabilities that often lead them right back into trouble.

More than ever, shareholders pay the price.

Shareholders may own the companies that seek bankruptcy protection, but a system that offers rich rewards to fast-moving bond traders, entrenched managements, professional bankruptcy specialists and a few choice creditors holds precious little potential upside for investors.

"We're in a different world today, where creditors, banks and big investors are really in the catbird seat," said Elizabeth Warren, a Harvard University professor who chaired a 1997 federal commission charged with reviewing bankruptcy practices. "Their position is that equity shareholders should have no say in the proceedings."

As Northwestern University professor Martin Stoller puts it: "The rules are so stacked against shareholders."

All told, the loss of shareholder wealth in bankruptcy cases is immense, reaching a new pinnacle in the Enron Corp. debacle that saw America's seventh-largest company go bust in a matter of weeks.

Among this year's largest filings, for example, 20 companies saw more than a quarter-trillion dollars in combined market capitalization wiped out from their recent market peaks to their current levels.

More public companies than ever--231 and counting--have filed for protection under Chapter 11 of the Bankruptcy Code this year as the economy slid into its first recession in a decade, according to BankruptcyData.com, a Web site run by New Generation Research in Boston. That tops last year's record of 176 as the economy began to weaken; perhaps more troubling, the number in 1999 also approached record levels, even as the economy and stock market sailed along.

And the debt they carry is more onerous than ever: When Enron imploded into the largest single bankruptcy in history, the Houston-based energy giant listed $62 billion in assets and a whopping $32 billion in liabilities. All told, defaulted and distressed debt has an estimated face value of $740 billion, according to Edward Altman, a finance professor at New York University's Stern School of Business and a leading bankruptcy authority.

Enron is among the three dozen companies to file this year listing more than $1 billion in debt, another record, Altman said. The scale, he noted, "is stunning."

The widespread nature of the huge debt load is remarkable, adds Nell Minow, one of the most prominent U.S. shareholder activists, noting that many acquirers of distressed securities are cavalier toward the risk.

"Everyone thinks they're going to get bailed out," she said.

Investors at end of line

All this is yet another house of cards crashing in on stockholders who are already reeling from revelations about bad corporate accounting, conflicts of interest among analysts who touted stocks and overly exuberant brokers who pushed clients into equities at the peak of the market bubble. With lightning speed, highly rated companies with household names hit the skids, leaving investors at the bottom of the food chain in the reorganization process.

While the declining economy played an important role, and much of the hand wringing will center on banks' clamping down on credit lending, many other factors contributed to the bankruptcy explosion.

During the boom years, when the economic engine roared and seemingly no one could see any serious risk ahead, companies loaded up on easy money, with corporate debt growing to 88 percent of the gross domestic product in the third quarter. Lenders apparently used attractive loan terms to win participation in big merger and other investment banking payouts.

"It's pretty clear there is a tie between credit commitments and the allocation of investment banking business," said John Feng, a vice president of the Greenwich Associates consultancy, which has studied the issue.

Accounting errors and misdeeds also are a factor in the skyrocketing number of corporate bankruptcies, notes Lynn Turner, a former Securities and Exchange Commission chief accountant who is now a professor at Colorado State University.

"Management teams tried to fudge numbers to achieve what they told the market they were going to do, and the auditors turned around and gave them a pass. We're going to have to have additional oversight of auditors and more detailed rules," Turner said.